September 20, 2012

Senate Hearing on Offshore Profit Shifting and the U.S. Tax Code

The Senate's Permanent Subcommittee on Investigations is conducting a hearing this afternoon on "Offshore Profit Shifting and the U.S. Tax Code." The witnesses providing testimony, their prepared statements, and a link to the hearing are available at this link. The Subcommitte's memo from Chair Levin and Ranking Member Coburn, is available here: Download PSI. memo on offshore profit shifting.092012

The first panel included Stephen Shay, a well-respected international tax expert at Harvard Law School, Download Testimony (79 KB) Shay noted that the legislative gridlock today requires us to "protect our existing tax base; indeed, it would be irresponsible not to try to increase revenue where it is consistent with good tax policy. This is good for the deficit and dealing responsibly with the deficit is good for jobs." He went on to discuss the Senate's investigation of Microsoft's ability to shift income to low-tax jurisdictions.

This data illustrates in broad but concrete terms what has been shown in aggregate data, namely, that U.S. multinational companies aggressively locate earnings in low-tax locations. Indeed, to give one measure of the scale involved, the companies in these low-tax jurisdictions employed only 1,914 of Microsoft’s 90,000 employees, yet they earned $15.4 billion in earnings before tax or over $8 million per employee (compared to an approximate average of $311,900 for all microsoft employees.

We do not have sufficiently granular information to form a view whether these results are consistent with existing transfer pricing regulations. Whether they are or are not, these results are not consistent with a common sense understanding of where the locus of Microsoft’s economic activity, carried out by its 90,000 employees, is occurring. The tax motivation of the income location is evident.

***

Income shifting to tax-favored jurisdictions is the Macondo Well of the international tax system, except it is not a sudden catastrophe and the blow-out is not under control. ... But the damage is real. Inadequate tax revenue has contributed to cut backs in vital government services in developed countries; the harm is worse in developing countries where scarce revenues are allocated among dire needs. ... [I]ncome shifting to low-taxed jurisdictions only can be partially addressed by increased enforcement. We also must address core issues in the way the arm's length standard has been permitted to be applied under existing U.S. regulations and the OECD's transfer pricing guidelines. The arm's length standard often has been interpreted or applied mechanically giving rise to results that do not pass a common sense reality test. ... Proposals to strengthen Subpart F by the Administration [also] move in the right direction.

all Microsoft employees).

It also included Reuven Avi-Yonah, at Michigan School of Law, Download Testimony (38.8 KB). Avi-Yonah reminded the Senate of the history of problems associated with the transfer of intangibles to offshore affilittes, which resulted in "economically unjustified" avoidance of taxes, leading Congress to revise the transfer-pricing provision in section 482 in 1986.

Congress responded [to multinationals' transferring ownership of intangibles to tax haven affiliates and claiming non-taxation of associated profits in the U.S.] in 1986 by revising IRC section 482 for the only time in its long history, adding the requirement that whenever an intangible is transferred to an offshore affiliate, whether by way of sale, license, or contribution to capital, a royalty must be paid that is "commensurate with the income" generated by the intangible. The general understanding of this "super-royalty" rule was that it required gradually increasing the royalty to bring all the profits from the intangible back onshore.

The results of this Subcommittee’s investigation show that we are now back where we were before 1986. As a result of a series of Treasury and IRS mistakes, the Congressional intent behind the 1986 amendment to section 482 has been completely undermined. U.S. multinationals are once again able to concentrate almost all their profits from intangibles developed in the U.S. in select offshore jurisdictions with very low effective tax rates. In my opinion, this suggests that the time has come for Congress to once again revise the statutory language to close the loopholes that make these results possible. Specifically, Congress should (a) override "cost sharing," which is the regulatory regime that undermines the super-royalty rule, and (b) repeal IRC 954(c)(6) and the application of "check the box" to costlessly shift profits from one offshore jurisdiction to another, since it is that shift that makes the transfer of profits out of the U.S. so appealing. Id.

These two academics are substantiating what we all have seen--that multinationals have found end-runs around the various attempts to ensure that their profits are currently taxed, and are successfully offloading profits to tax havens and thus lowering their U.S. taxes. It is time to enact reasonable reforms that put an end to these practices to prevent the drain from the fisc into corporate managers' and owners' pockets.

The second panel was devoted to Bill Sample,Download Testimony (112.3 KB). Sample is the corporate vice president for worldwide tax at Microsoft, one of the companies that has "used transactions with subsidiaries in Puerto Rico, Ireland, Singapore and Bermuda to save at least $6.5 billion in taxes." Richard Rubin, Microsoft Avoided Billions in U.S. Tax, Senate Memo Says, Bloomberg Businessweek (Sept. 20, 2012) (based on a release to media of the Senate memo). Notably, Microsoft's "retail" business operates primarily out of tax havens: Ireland, Singapore and Puerto Rico. The company claims that each of their tax haven enterprises represent "significant investment in infrastructure and headcount." Id. But of course that investment has been made with the goal of avoiding US tax, and has contributing to the outsourcing of US jobs to other countries. As I have said in many other settings, the fact is that Microsoft would never sell its intellectual property to another company, and the transfer prices it uses to permit half of its profits to be earned offshore are inherently suspect.

The problem, of course, is that Congress has riddled the Subpart F and other rules in the Code with exceptions that make it incredibly easy for companies like Microsoft to succeed in offshoring profits legally, and Treasury has a set of regulations on transfer pricing that do not address the realities of today's global marketplace in workable ways. Congress needs to pull back from the "lighter" Subpart F rules it passed under the Bush regime and Treasury needs to distance itself from the too-close relationship with tax lobbyists so that it takes on regulatory projects that are what the nation needs, rather than satisfying the corporate tax wish-lists. As Levin told reporters today, "These loopholes and abuses exact a tremendous cost. What these gimmicks do is shift the burden of taxes onto citizens and businesses that don't use armies of lawyers and accountants." Rubin, op.cit . I'd add that domestic businesses that hire American workers are particularly hurt by the ability of multinationals to offshore their profits, since the domestic businesses are forced to compete on an unlevel playing field with the advantaged multinationals.

Comments

Senate Hearing on Offshore Profit Shifting and the U.S. Tax Code

The Senate's Permanent Subcommittee on Investigations is conducting a hearing this afternoon on "Offshore Profit Shifting and the U.S. Tax Code." The witnesses providing testimony, their prepared statements, and a link to the hearing are available at this link. The Subcommitte's memo from Chair Levin and Ranking Member Coburn, is available here: Download PSI. memo on offshore profit shifting.092012

The first panel included Stephen Shay, a well-respected international tax expert at Harvard Law School, Download Testimony (79 KB) Shay noted that the legislative gridlock today requires us to "protect our existing tax base; indeed, it would be irresponsible not to try to increase revenue where it is consistent with good tax policy. This is good for the deficit and dealing responsibly with the deficit is good for jobs." He went on to discuss the Senate's investigation of Microsoft's ability to shift income to low-tax jurisdictions.

This data illustrates in broad but concrete terms what has been shown in aggregate data, namely, that U.S. multinational companies aggressively locate earnings in low-tax locations. Indeed, to give one measure of the scale involved, the companies in these low-tax jurisdictions employed only 1,914 of Microsoft’s 90,000 employees, yet they earned $15.4 billion in earnings before tax or over $8 million per employee (compared to an approximate average of $311,900 for all microsoft employees.

We do not have sufficiently granular information to form a view whether these results are consistent with existing transfer pricing regulations. Whether they are or are not, these results are not consistent with a common sense understanding of where the locus of Microsoft’s economic activity, carried out by its 90,000 employees, is occurring. The tax motivation of the income location is evident.

***

Income shifting to tax-favored jurisdictions is the Macondo Well of the international tax system, except it is not a sudden catastrophe and the blow-out is not under control. ... But the damage is real. Inadequate tax revenue has contributed to cut backs in vital government services in developed countries; the harm is worse in developing countries where scarce revenues are allocated among dire needs. ... [I]ncome shifting to low-taxed jurisdictions only can be partially addressed by increased enforcement. We also must address core issues in the way the arm's length standard has been permitted to be applied under existing U.S. regulations and the OECD's transfer pricing guidelines. The arm's length standard often has been interpreted or applied mechanically giving rise to results that do not pass a common sense reality test. ... Proposals to strengthen Subpart F by the Administration [also] move in the right direction.

all Microsoft employees).

It also included Reuven Avi-Yonah, at Michigan School of Law, Download Testimony (38.8 KB). Avi-Yonah reminded the Senate of the history of problems associated with the transfer of intangibles to offshore affilittes, which resulted in "economically unjustified" avoidance of taxes, leading Congress to revise the transfer-pricing provision in section 482 in 1986.

Congress responded [to multinationals' transferring ownership of intangibles to tax haven affiliates and claiming non-taxation of associated profits in the U.S.] in 1986 by revising IRC section 482 for the only time in its long history, adding the requirement that whenever an intangible is transferred to an offshore affiliate, whether by way of sale, license, or contribution to capital, a royalty must be paid that is "commensurate with the income" generated by the intangible. The general understanding of this "super-royalty" rule was that it required gradually increasing the royalty to bring all the profits from the intangible back onshore.

The results of this Subcommittee’s investigation show that we are now back where we were before 1986. As a result of a series of Treasury and IRS mistakes, the Congressional intent behind the 1986 amendment to section 482 has been completely undermined. U.S. multinationals are once again able to concentrate almost all their profits from intangibles developed in the U.S. in select offshore jurisdictions with very low effective tax rates. In my opinion, this suggests that the time has come for Congress to once again revise the statutory language to close the loopholes that make these results possible. Specifically, Congress should (a) override "cost sharing," which is the regulatory regime that undermines the super-royalty rule, and (b) repeal IRC 954(c)(6) and the application of "check the box" to costlessly shift profits from one offshore jurisdiction to another, since it is that shift that makes the transfer of profits out of the U.S. so appealing. Id.

These two academics are substantiating what we all have seen--that multinationals have found end-runs around the various attempts to ensure that their profits are currently taxed, and are successfully offloading profits to tax havens and thus lowering their U.S. taxes. It is time to enact reasonable reforms that put an end to these practices to prevent the drain from the fisc into corporate managers' and owners' pockets.

The second panel was devoted to Bill Sample,Download Testimony (112.3 KB). Sample is the corporate vice president for worldwide tax at Microsoft, one of the companies that has "used transactions with subsidiaries in Puerto Rico, Ireland, Singapore and Bermuda to save at least $6.5 billion in taxes." Richard Rubin, Microsoft Avoided Billions in U.S. Tax, Senate Memo Says, Bloomberg Businessweek (Sept. 20, 2012) (based on a release to media of the Senate memo). Notably, Microsoft's "retail" business operates primarily out of tax havens: Ireland, Singapore and Puerto Rico. The company claims that each of their tax haven enterprises represent "significant investment in infrastructure and headcount." Id. But of course that investment has been made with the goal of avoiding US tax, and has contributing to the outsourcing of US jobs to other countries. As I have said in many other settings, the fact is that Microsoft would never sell its intellectual property to another company, and the transfer prices it uses to permit half of its profits to be earned offshore are inherently suspect.

The problem, of course, is that Congress has riddled the Subpart F and other rules in the Code with exceptions that make it incredibly easy for companies like Microsoft to succeed in offshoring profits legally, and Treasury has a set of regulations on transfer pricing that do not address the realities of today's global marketplace in workable ways. Congress needs to pull back from the "lighter" Subpart F rules it passed under the Bush regime and Treasury needs to distance itself from the too-close relationship with tax lobbyists so that it takes on regulatory projects that are what the nation needs, rather than satisfying the corporate tax wish-lists. As Levin told reporters today, "These loopholes and abuses exact a tremendous cost. What these gimmicks do is shift the burden of taxes onto citizens and businesses that don't use armies of lawyers and accountants." Rubin, op.cit . I'd add that domestic businesses that hire American workers are particularly hurt by the ability of multinationals to offshore their profits, since the domestic businesses are forced to compete on an unlevel playing field with the advantaged multinationals.